Guest Post: TIPS Vs Treasuries
Submitted by Jeff Borack of Kerrisdale Capital
TIPS vs Treasuries
Treasury Inflation Protected Securities are government issued
securities adjusted bi-annually for inflation. When the urban consumer
price index (CPI-U) increases, the face value and the yield on TIPS
also increases. If investors are concerned about inflation, TIPS are
one method of protection (you can buy them directly from the government
here: http://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm) given that they are directly tied to inflation. Unlike other investments which “should” appreciate in an inflationary environment, TIPS do appreciate.
The spread between TIPS and Treasuries represents the market’s
inflation expectation. It’s just as impossible for the government to
default on TIPS as Treasuries, so default risk is the same. Investors
will accept a lower yield on TIPS by the amount they expect to recoup
from inflation adjustments. While investors who hold normal treasuries
to maturity are guaranteeing their interest rate, TIPS holders are guaranteeing their purchasing power,
making TIPS an attractive alternative for many savers. The chart from
Bloomberg below shows the current yields available on TIPS in green,
and treasuries in orange:
As we can see here, the 2-year spread between TIPS and Treasuries is
a bit over one percent. The 5-year spread is at about 1.75%, and the
10-year spread is a little over 2%. It’s a bit surprising to see such
low spreads given the inflation expectations investors claim to have. Everywhere we look, investors are fretting about inflation… why aren’t they buying TIPS?
Even if we were not expecting an inflationary environment, TIPS might still be cheap relative to treasuries. The chart below plots the year-over-year percent change in CPI-U as of last month:
The average annual inflation over this time period has been 3.8%.
The chart is volatile, and there have been lengthy multi-year periods
where inflation has been less than 2%. But even if we assume a normal
inflation rate will be only 3% per year, investors can reduce their
risk of losing significant purchasing power and increase
their expected return by about 1%, by moving from treasuries (and CDs
and savings accounts) into TIPS. The combination of lower risk and
higher return is a rare opportunity in finance. We’re at a loss to
understand why investors (especially those with inflation fears) would
hold treasuries, CDs, or excess cash when they could buy TIPS.